Analysts’ forecast optimism: The effects of managers’ incentives on analysts’ forecasts

Abstract

Sell-side analysts are rewarded for forecasting accurately, yet prior literature shows that analysts’ earnings forecasts exhibit an optimistic bias, which is generally attributed to analysts’ compensation structure or a desire to extract private information from managers. Building upon the theoretical model from Beyer (2008), we propose that analysts make decisions about forecasting while considering both optimism and accuracy: analysts forecast optimistically in anticipation of managers’ upward manipulation of earnings in order to meet or beat forecasts. We find that the upward bias in analysts’ earnings forecasts is increasing in the cost of managers missing forecasts (measured using leverage) and the volatility of earnings (using the standard deviation of ROA), and decreasing in the cost of earnings management (measured using Big 4 auditor, a pre- vs. post-Sarbanes Oxley test, and a DID test of larger vs. smaller firms, pre- vs. post-Sarbanes Oxley Section 404 implementation). Further tests suggest that these results are attributable to a lower (higher) incidence of earnings management for Big 4 and post-Sarbanes Oxley firms (firms with higher leverage and more volatile earnings). Our results provide evidence of a rational explanation for analysts’ decision making that considers both forecast optimism and a strategy to forecast accurately.